Accounting versus Prudential Regulation

Abstract

We develop a framework to study how accounting measurement and prudential regulation interact to affect a bank's incentives to originate credit. Our main result is that the accounting measurement system and bank leverage are policy tools that should be used in tandem, generating more value than systems that rely either on accounting regulation or on prudential regulation. An important application of our analysis is on the current debate on the appropriate loan loss provisioning model. We show that while banks engage in excessive risk-taking under an incurred loss model, an expected loss model can lead to excessive liquidations. More interestingly, we show that as credit conditions in the economy improve, the optimal measurement system moves towards an expected loss model. Conversely, as credit conditions deteriorate, the optimal measurement regime tilts more towards an incurred loss model.